Financial decisions are often complex in nature and require business heads / managers to take a calculated approach to problem-solving. The decisions majorly revolve around the management of working capital, raising and allocating funds for various projects / expenses and managing inventory/receivables. Management decisions in turn are based on these important financial decisions that are made by using a range of analytical tools. It could be ratio analysis, studying comparative statements, trends, benchmarking or incremental analysis etc. We will be discussing the various features of Incremental Analysis, its benefits in decision-making process and also touch upon the steps involved in the actual problem-solving. If you’d like a jump start, you can try this course on Ratio Analysis and interpretation.
Incremental analysis, also called differential or marginal analysis, is the simplest approach to solving complex business decisions. It uses the ‘cost-behavior concept’ to analyze how each cost (fixed or variable) will affect the different alternatives of future income. If you are a manager or business head, facing tough decision-making situations on a regular basis, then you should first check out this course to understand the basics of business finance.
What is Incremental Analysis?
Whenever you are required to make a business decision, you have to choose from the available choices/alternatives. Incremental analysis studies the cost and revenue differences between the various alternatives to help you arrive at the decision. This problem-solving tool mainly focuses on three of the major cost components that need to be understood thoroughly for an effective analysis:
Relevant Cost – The costs and revenues that are different amongst the alternatives as against those that remain same, are called relevant costs (or relevant benefits). For example, say you have to decide whether to buy a new piece of machinery or get the existing one repaired. Here, the insurance and maintenance costs would be different hence relevant; whereas the revenue earned from its operation might be the same therefore, non-relevant.
Sunk Cost – Costs that have already been incurred and have no impact on the decision making process are called sunk costs and these are never relevant. Some examples of sunk costs are advertising expenses, investing in an asset that fails to earn returns, product research expenses etc.
Opportunity Cost – This is the cost of losing a potential benefit from another alternative when you made a choice and these are necessarily relevant costs. For example, you decided to buy a vacant land in the suburbs instead of investing in a commercial complex in the city. The income that you could have earned by leasing out the commercial space becomes your opportunity cost.
The main aspect of incremental analysis is to correctly identify the relevant costs and revenues between the various options at hand and use them to arrive at the decision. Once you have identified and separated them into variable and fixed costs, you can quickly solve the problem and make an ‘informed’ decision.
If you want to learn more on the decision-making components of Incremental Analysis, skip right ahead to our guide to finance and accounting.
Why Should You Use Incremental Analysis?
Most often managers spend a lot of their precious time in studying all the data available on the different choices, relevant or not. This leads to unnecessary wastage of productive time that they could have effectively used elsewhere. Since the non-relevant costs have no play in the final outcome of a decision, it doesn’t make business sense to examine them.
By using Incremental Analysis, managers can focus on the relevant costs to arrive at short-term business/financial decisions quickly and more effectively.
You can use this simple approach to make decisions that fall under various categories such as:
- Special order decisions – While deciding whether to accept special orders with lower than normal rates in order to book short-term profits
- Limited resource decisions – On choosing a product from a range of products for allocating limited resources to its development or production
- Make or buy decisions – When you must decide whether to manufacture a product or develop software in-house or procure it from an outside supplier
- Sell, scrap or rebuild decisions – Would you sell a product with its existing features and capture the market, scrap the obsolete products with minimal loss or invest more on enhancing its features?
You can easily make these kinds of short-term decisions with the help of Incremental Analysis to achieve a smoother and less time-consuming decision-making process. Make sure to gather the right financial information on the various alternatives and make sure it is reliable for an error-free decision. This course on project financial modelling will show you which aspects you should focus on.
Managers across businesses normally prefer to use the Incremental Analysis technique as against the full costing method because of its various benefits. It not only saves their time but also gives accurate results that are sufficient to choose the best alternative with the information available.
Steps Involved in Incremental Analysis
Note: As stated earlier, incremental analysis uses only the relevant costs and ignores the non-relevant costs. The costs and revenues that remain same are non-relevant whereas the costs and revenues that change across alternatives are relevant and must be considered.
Step 1 – Compare the revenues that are possible under both the alternatives, eliminate the revenues that are non-relevant and list the revenues that are relevant. Determine the incremental revenue here.
Step 2 – Now repeat the above exercise for the costs that you will incur under both the alternatives. Keep the relevant costs (like opportunity cost) and do away with the non-relevant costs (like sunk costs). Determine the incremental cost here.
Step 3 – Differentiate the relevant costs into fixed and variable costs and arrive at the difference amount (you will find that this is actually the incremental cost savings)
Step 4 – Finally tabulate the incremental revenue, incremental cost and incremental cost savings, sum up all the amounts and find out the most profitable choice among the alternatives available. If the incremental revenues are more than the incremental costs, then the profits would increase whereas if the revenues are lower than the costs, the profits would decrease.
Based on the above mentioned steps, you can make faster, smarter and effective decisions. It’s as simple as that!
Effective use of Incremental Analysis
Incremental analysis is an effective tool to determine the best alternative that can yield the highest revenues with the least costs. Gathering the required financial information on all the options is as important as carrying out the actual analysis. The quality and reliability of the information also contribute to the success of using this tool in business decisions. Keep these few aspects in mind before you start practicing it in your business decisions. You can use this tool for solving problems across various functions of your business, be it production, sales or marketing etc. It’s also important for your financial accountants, management executives and others in the decision-making chain to understand the concepts of relevant and non-relevant costs, fixed and variable costs, net benefit and incremental analysis etc.
In short, incremental analysis is a simple but powerful analytical tool that can help you directly compare the benefits of choosing the best option. It leads to quicker, simpler and effective business decisions to maximize profits and significantly reduce the costs. For a complete course on incremental analysis, basic concepts of cost accounting and management, go right across to our course on financial accounting.